Is the Party Over?

February 21, 2013 By Mad Hedge Fund Trader

The simple answer is no, not yet. But the neighbors have complained about the noise and called the cops. Today’s 108-point drop in the Dow, and 19-point decline in the S&P 500 does mean that the straight line, parabolic phase of the bull market is over.

One of the most overbought markets in history is finally taking a pause. We traders are now going to have to work a little harder to earn our crust of bread.

Of course, I saw this one coming a mile off. I was expecting some short of dump as the March sequestration recklessly approached. That’s why I have been running hefty 50% in short positions against even beefier longs.

It is also why there has been a recent dearth of Trade Alerts, only two in the last two weeks, the least since last July. Rather than add to longs up here in the stratosphere, I instead let my existing call spreads rapidly recede in my rear view mirror.

We saw the selloff spread across all asset classes, like the waves propagated by an empty champagne bottle tossed into a swimming pool. The Euro (FXE) took a big hit against the dollar, plunging more than a cent. Gold (GLD) absolutely took it on the kisser, cratering $42, followed by silver (SLV), down $1. Crude gave back $2.50. Thankfully, the Japanese yen (FXY), (YCS) only churned. Strangely, Treasury bonds (TLT) barely moved when they should have been up at least two points, continuing their recent stagnation near one year lows.

This was the correction that was begging to happen. You saw it in the Volatility Index (VIX) that was probing new five year lows. You almost needed a microscope to detect the recent daily trading ranges.

All it took was some out of date Fed notes to light the match. Suddenly, there are more members opposed to infinite and unending quantitative easing than previously understood. Perhaps it could end sooner than later? So that was a surprise? Hey, you live by the Fed, you die by the Fed.

So how much pain do we have to suffer before our assault on 1,600 resumes? The no brainer retracement level from here is the 50-day moving average across all the indexes. That works out to 1,471 for the (SPX), (-2.6%), 13,569 for the Dow (-2.6%) and 87.23 for the Russell 2000 ETF (IWM), (-4.0%).

As for the positions in our model-trading portfolio, we are in pretty good shape. Our short positions in the (SPY) are now clearly toast and should expire at zero on March 15, only 17 trading days from here. We may take some heat on our equity longs. But for us to really lose money on them, the markets would have to give up almost all of their 2013 gains. I don’t see that happening. If I am right, the year to date performance should grind up to an eye-popping 32% in three weeks.

We have a shot at a dream scenario here. Let the market fall, but not enough to touch our call spreads. Everything expires at their maximum point of profitability in mid March. Then we will have a 100% cash position right at the bottom of a correction.

Next, we replay the whole strategy one more time to make another 30%. We’ll do that by piling into call spreads for the indexes again, as well as single stock spreads for cyclicals, like industrials and consumer discretionaries, and health care. One can only hope.

As one often hears when traveling around Asia, the Chinese character for crisis is also the one for opportunity. Looks like more are just setting up just over the horizon.

Is the Party Over?

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It should not be assumed that the methods, techniques, or indicators presented in these pages will be profitable or that they will not result in losses. Past results are not necessarily indicative of future results. Examples presented on these pages are for educational purposes only. These set-ups are not solicitations of any order to buy or sell. The authors, the publisher, and all affiliates assume no responsibility for your trading results. There is a high degree of risk in trading.